Equities Have Surged, but Valuations May Still Be Cheapish

Traders enter the final week of February with the major equity averages oh-so-close to breakeven for the year. The blue-chip Dow Jones Industrial Average ($INDU) sloughed off the Greek debt drama, credit tightening in China and a surprise policy change from the Federal Reserve to tack on 500 points in just the last two weeks.And all the while -- almost as a sideshow to those macroeconomic divas -- earnings season was humming along. Fortunately for everyone, it's pretty much over, and it's come in pretty much as expected. Of the 422 companies in the S&P 500 ($INX) that have reported quarterly earnings so far, 72% have beaten Wall Street's estimates, according to Thomson Reuters. (It used to be that about 60% of companies beat estimates, but it seems 70% is "the new normal.") Top-line numbers and guidance have been upbeat, too.

Now, regardless of the reasons, anytime the Dow vaults 5% in two weeks it's probably a good time to check in on equity valuations. With earnings season winding down, analysts have fresh "E"s to plug into the market's price/earnings (P/E) multiple. And by one reckoning, at least, stocks look neutral at worst to -- yes -- cheapish.

Stocks Are Right at Their Long-Term Median Valuation

Bullish Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW), recently took a look at valuations with the latest earnings data, and the results might give some bears pause.

Sonders' favored way of measuring valuation takes four-and-a-half years of historical earnings ("normalized" to exclude special charges and the like) plus two quarters of forecasted earnings -- and then averages the two. The nice thing about this approach is that it gives more weight to actual, reported earnings than guesstimated ones (even if it does subtract items that could come back to haunt investors).

At any rate, by this tally, the market stands precisely at its long-term median valuation of a bit more than 17 times earnings. "In addition, in light of very tame inflation, it could be argued that the market is a bit cheaper than it's been historically when inflation has been in the current zone," Sonders writes. Indeed, if the data holds up, stocks are undervalued by about 15%.

Will Rate Hike History Repeat?

Separately, providing more (though perhaps meager) fodder for the bulls, Fed rate hikes are hardly a bad sign for equities if recent past performance is indicative of future returns.

John Stoltzfus, market strategist at Ticonderoga Securities, notes that from June 2004 to June 2006, the Fed raised rates 17 times in quarter-point increments, and then it held fast until October 2007. Over that same span, the S&P 500 gained 47%, good for an annualized return of 13%. "We're not so bold as to say that history will repeat itself this time," Stoltzfus writes, "but to paraphrase Mark Twain, it just might rhyme."